The argument of active v. passive focuses on how the building blocks (asset classes) of the portfolio are constructed. However, we know from the Brinson study that the primary driver of the investor’s eventual performance is the relative weighting of the asset classes the investment manager selects, not whether those asset classes were actively or passively constructed.

The affirmative decision to allocate capital among the available asset classes ought to be the reserved exclusively for the investment manager, and it is this decision which drives the ultimate performance of the portfolio. The manager’s allocation to stocks v. bonds, large cap v. small cap, growth v. value, etc. are the primary determinants of portfolio performance, NOT whether those allocation decisions are implemented using an active v. passive approach. An investment manager could build a “bad” portfolio using only passive products in the same way a manager could build a “good” portfolio using actively managed products. (Good and bad in the prior sentence is defined by the risk and return characteristics of the portfolio over an extended holding period.)

Many investment managers spend too much time debating the relative merits or deficiencies of active vs. passive management and spend almost no time establishing key performance indicators to measure the strategic and tactical allocation decisions they are making irrespective of whether they abide by an active v. passive approach. If 90% of the results will flow from the investment manager’s strategic and tactical allocation decisions, shouldn’t the effort be placed on measuring the effect of these decisions rather than whether the investment manager uses active or passive building blocks in their implementation?

If the capital owner is a trustee for someone else’s money (individual trustee, ERISA trustee, endowment trustee, or business manager) this practice of establishing several key performance indicators for the investment manager’s strategic and tactical allocation decisions is central to their fiduciary duties.

Following is a link to a white paper that explains these benchmarking best practices.

At Anodos, we help our clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance, or accept referral fees. We don’t have a horse in the race.

The Problem: You are a business manager(1), and it is either explicitly or implicitly the case that you are responsible for monitoring the activities of the investment managers that have been entrusted with your clients’ capital. (If you are not a business manager or disagree with this statement, stop reading. This paper does not apply to you.) The problem is that most business managers don’t have the internal systems, licensure, training, staff support, or time to conduct the independent monitoring functions that their clients expect and the law requires(2).

The Way It Is: In response to this problem, many business managers rely on the current money managers to evaluate their own investment acumen. These self evaluations produce predictable results. The incumbent managers typically report, “We did great! We are above average!” Looking for a more objective analysis, business managers frequently ask a competing money manager to review the portfolio designed by the current money manager. Again this “peer review” has predictable results; the competing money manager reports that the incumbent manager is a knucklehead and that the Business Manager should fire the incumbent manager and higher the candidate manager because they are “above average.”

The Way It Should Be: It should be easy to answer the question, “Is my client’s investment manager doing a good job?” And it is easy if the business manager takes the time to define what the job is that the investment manager is being hired to do. Good investment governance begins with the business manager helping their client document the outcomes that the investment manager is being hired to accomplish. Not only should the job description include the financial objectives being pursued, but also the parameters or investment principles that the client holds. This job description will include, at a minimum, the client’s targeted rate of return, the anticipated contribution & distribution rate from the portfolio, the agreed upon fee to be paid to the investment manager, the maximum allocation to illiquid investments, a policy regarding the minimum amount to be allocated to a capital reserve (a “bond bunker” made up of short-term, investment-grade bonds), and how frequently and by which party independent monitoring and review will be conducted.

Your Job v. Their Job: Once the “Job Description” has been approved by the client and delivered to the investment manager it is important that the business manager’s role be constrained to monitoring the actual results versus the documented objectives. Too many business managers are willing to accept responsibility for strategic and tactical portfolio decisions which are beyond their contractual responsibility, legal authority, or licensure. It is reasonable for the business manager to have an opinion that their client relies upon, but if the business manager does not have the legal authority to do so, their personal views should not dictate policy. The allocation, strategy, and tactics are the investment manager’s responsibility, though they must remain consistent with the “Job Description” that has been given to them. The business manager’s job is to be the arbiter of whether the investment manager’s recommendations stay within these defined bounds. If the business manager confuses their job (monitoring and reporting) with the investment manager’s job (investment allocation and tactics), the business manager opens the door for a charge by the investment manager that “the business manager told me to do it this way. It’s not my fault that things went badly.” The investment managers have and will continue to make this claim under oath because in most cases it is true.

The Portfolio Audit: A truly objective portfolio audit is designed to compare the actual outcome produced by the investment manager’s decisions against a series of predefined objectives and key performance indicators. To preserve the independence and objectivity of the review process, the auditor must be disqualified from ever managing the portfolio that is being audited. The auditor should also have a depth of experience and training to conduct such an audit. Knowing how to manage money and knowing how to conduct a portfolio audit are close disciplines, but they are not the same. There are five central questions that any portfolio audit should answer:

Is this portfolio likely to accomplish the desired objective?

Is the return that was realized appropriate given the risk taken?

Is the portfolio reasonably diversified?

Is the advisory fee fair given the portfolio size and objectives being pursued?

Are there any operational risks with the investment manager or their company?

The Admonition: That’s how to watch the hen house. Go and do likewise.

Anodos helps clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance or accept referral fees. We don’t have a horse in the race.